The Inflation Reduction Act (IRA) introduced many tax incentives to promote clean energy and sustainable practices, for businesses and individuals. These include extended and expanded tax credits for investments in renewable energy and energy efficiency. For instance, some of these credits offer increased amounts if your projects meet specific job quality and opportunity standards. Others are transferable, or available to a broader range of taxpayers.
So if your private equity firm makes environmentally conscious investments, you can leverage these incentives to enhance your returns.
In this blog, we’ll explain how to promote sustainable and socially responsible business practices while getting the most bang for your buck.
Understanding ESG Investing in Private Equity
Environmental, social, and governance (ESG) factors emphasize responsible and sustainable business practices. In a private equity context, ESG investing focuses on:
- Environmental: Your company’s impact on the environment. For example, its carbon footprint, waste management, and use of resources like renewable energy.
- Social: Your policies and practices on labor standards, including community engagement, diversity and inclusion, and client relations.
- Governance: Your corporate governance structures. This encompasses how diverse your board is. It also includes any anti-corruption measures you have in place and your firm’s overall transparency.
Essentially, this means that ESG investing involves actively seeking opportunities that create long-term value for your investors, while positively impacting society and the environment. So how do you integrate these factors into your investment decisions?
Generally, this requires an ESG framework across the typical investment lifecycle.
Pre-investment
ESG factors should be integrated into your financial and operational analyses during investment due diligence. This includes identifying potential risks around regulatory compliance, such as resource dependency. Similarly, you need to highlight opportunities, like entering renewable energy markets. This means that your firm should use tools like materiality assessments and third-party ESG ratings to guide your decision-making.
Portfolio management
To implement ESG investing initiatives into your portfolios, you’ll need to adopt energy-efficient practices, improve supply chain transparency, or create employee wellness programs. You’ll also need to track ESG performance through key performance indicators (KPIs) and benchmarks established in your industry.
Finally, don’t underestimate the importance of ensuring you make regular ESG reports to your stakeholders – this is a great way of ensuring accountability.
Exit strategy
Any ESG investments made in your portfolios should be highlighted if you sell. That way, you can easily demonstrate how the portfolio has created value. Remember that firms with strong ESG credentials can have higher valuations than those without, because they have reduced compliance risks, and will often align with investor priorities.
ESG Criteria for Risk Management and Value Creation
By identifying ESG risks – which can range from reputational damage to regulatory fines – your firm can lower its potential liabilities. For instance, identifying and assessing climate risks like tornados can guide your finance team’s decisions about investing in regions prone to extreme weather.
Avoiding risks is crucial, since ESG investing can create significant value for your firm. In fact, it can actually improve operational efficiency and save you money in the long run, through reduced energy consumption, or improving your workforce productivity through better labor practices. ESG investments can also help you identify new market opportunities for innovative product offerings, like sustainable goods or services. This, in turn, can help with enhancing your reputation and improving stakeholder trust.
This can be a great help when attracting investors. Also, remember that strong ESG practices can often provide increased access to funding. You see, governments and industry bodies are increasingly mandating ESG disclosures and incentivizing sustainable investments.
Tax Incentives and Benefits
Local and federal tax incentives are a great way to promote ESG investing, and come in many forms.
Tax benefits of environmentally sustainable investments
ESG investing opens up several possible tax credits for your firm. For instance, there’s the Investment Tax Credit (ITC). This provides a dollar-for-dollar reduction in your federal income taxes, provided that your firm makes investments in renewable energy properties. It is especially useful for solar developments. And under the IRA, you’ll get an extra 30% rate through at least 2025.
There’s also the Production Tax Credit (PTC), which offers a per-kilowatt-hour credit for electricity generated by qualified energy resources. That includes wind, biomass, and geothermal.
Several tax deductions are also available. For instance, you can make use of a Section 179D deduction for energy-efficient buildings. This is available for commercial buildings or commercial retrofit properties. And if you meet prevailing wage and apprenticeship requirements, you can get an increased deduction.
Incentives for social impact investments
The New Markets Tax Credit (NMTC) is a community development credit that incentivizes investments in low-income communities. It provides credits to investors who make equity investments in Community Development Entities (CDEs). Here, your firm can get a credit equal to 39% of your investment, which is distributed over seven years.
Similarly, if your business invests in Qualified Opportunity Zones (QOZs), you can defer and potentially reduce your capital gains taxes by reinvesting gains into Qualified Opportunity Funds.
Governance tax benefits
Admittedly, tax deductions specifically for corporate governance initiatives are limited. However, you can deduct a number of expenses related to establishing and maintaining effective governance structures. In fact, these are usually deductible as ordinary and necessary business expenses.
Structuring ESG Investments for Tax Efficiency
With strategic planning, it’s possible to structure ESG investing for tax efficiency. For example, consider using tax-advantaged investment vehicles, like municipal bonds issued for ESG-related projects.
Also don’t underestimate the effect of investing directly in ESG projects. This allows your firm to claim specific credits and deductions associated with those projects. The same is true for funds that specialize in ESG tax credits. After all, they’re designed to reward private organizations that prioritize environmental stewardship, social responsibility, and strong governance.
And if you have property investments, you can use Section 1031 exchanges. With these, you can defer capital gains taxes by reinvesting proceeds from the sale of one property into a similar property.
Compliance and Reporting Obligations
Compliance is integral to the effective implementation of ESG strategies. After all, in addition to helping you avoid penalties, compliance ensures transparency, accountability, and proper utilization of tax incentives.
This means you must be aware of ESG reporting standards and guidelines, whether through voluntary ESG reporting, or mandated by international structures.
At the same time, your firm will need to ensure it makes use of accurate record keeping. Maintaining detailed documentation is essential for substantiating tax incentive claims, and for stakeholder transparency. This includes records of all your investments, how they comply with eligibility requirements, and any correspondence between your business and the relevant tax authorities. It’ll also help you ensure that you are prepared in the event of a potential audit.
Risk Management and Contingency Planning
While we’ve covered the tax benefits associated with ESG investing, it’s also important to consider the potential risks. One of the most pressing issues is the complex regulatory landscape surrounding ESG investments.
Tax laws change all the time, so you’ll need to keep up to date with any potential changes and how these will affect your strategies. However, a tax professional can easily help you mitigate these issues and navigate the intricacies of compliance, while keeping you informed of any regulatory changes.
By incorporating ESG factors into your overall risk management framework, you’ll also be able to spot and resolve any potential risks. This includes embracing transparency in your reporting, and developing contingency plans for worst-case scenarios.
For guidance with tax efficient ESG investing, or help with your taxes, schedule a Discovery Call with one of our experts today!\
The information presented in this blog article is provided for informational purposes only. The information does not constitute legal, accounting, tax advice, or other professional services. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability of the information contained herein. Use the information at your own risk. We disclaim all liability for any actions taken or not taken based on the contents of this blog. The use or interpretation of this information is solely at your discretion. For full guidance, consult with qualified professionals in the relevant fields.